Friday, May 3, 2013

Scott Ritenour wrote a critique of Market Monetarism. I responded to his criticism of our supposed failings of basic theory here. I responded to his criticism of our view of the role of expectations here. Here I will discuss Ritenour's claim that Market Monetarists fail to understand the consequences of keeping nominal GDP on target.

Monetary inflation, therefore, will affect demands for certain goods first and then subsequent demands for different goods as the new money is spread through the economy. The step-by-step adjustment process during which the new money is absorbed necessarily results in real changes in relative prices and a real redistribution of wealth (Mises 1929, pp. 85-88; Mises 1938; Salerno 2010, pp. 202-03).

The market process by which an increase in the demand to hold money in the face of a fixed quantity of money leads to lower prices and wages and so an increase in the real quantity of money includes reduced money expenditures on goods and services. Nominal GDP level targeting requires that instead the nominal quantity of money rise to match any increase in the demand to hold money. Those particular people who choose to hold money reduce their expenditures on whatever goods, services, or financial assets they value less than the additional money balances. The newly-issued money is spent in some particular place or other. This could easily impact relative prices and the allocation of resources. The effect is exactly what would happen if those choosing to hold more money had instead spent that money on whatever those issuing the money purchased. The market economic system is especially good at making adjustments in the allocation of resources in response to just these sorts of changes in the composition of demand.

With a credit money system, those who choose to hold more money are choosing to accumulate a particular type of financial asset, and the banks (private or central) issue money by purchasing other financial assets--banks are financial intermediaries. If the quantity of money rises with the demand to hold money, the effects are exactly as if those accumulating the additional money had instead accumulated whatever financial assets (loans or securities) purchased by the banks with the newly-issued money.

The market process by which a reduction in consumption spending used to purchase financial assets results in lower market interest rates and more investment spending is reasonably well understood. This shift in the relative demands for different types of goods results in an appropriate reallocation of resources. Further, a shift in demand between different sorts of financial assets also results in adjustments in relative yields. This may result in some shift in the allocation of resources as well, but it is part of the normal operations of financial markets. If investors sell one company's bonds and purchase another company's bonds, it is not neutral, but neither is it disruptive.

As for the change in the real distribution of income, it is correct that an unanticipated deflation of prices would have resulted in an unanticipated transfer of wealth from debtors to creditors . Nominal GDP level targeting prevents this from occurring. So, the unanticipated gain that all creditors, including those holding money, would have received under a constant money supply regime would not occur. On the other hand, both the supply and demand for credit depend on the regime. It is illegitimate to focus on just this one comparison. In particular, nominal GDP targeting protects creditors from the impact of unanticipated inflation due to a decrease in the demand to hold money in the face of a constant quantity of money.

When considering the trend growth rate of nominal GDP, the higher the growth rate, the higher the nominal interest rate that creditors receive from debtors. Again, with a credit money system, that part of the money supply that bears interest, which is most of it, would pay a higher nominal interest rate due to a higher trend growth rate of nominal GDP. Interestingly, the amount of money people hold in checkable accounts of various sorts will constantly grow exactly in proportion to what each person is holding. For example, constant nominal GDP as suggested by Hayek or else the sort of "productivity norm" proposed by Selgin, would make holding hand-to-hand currency more attractive relative to checkable deposits. The nominal interest rate paid on checkable deposits would be lower, though the real return on them would be approximately the same.

The problem with this common trope of Austrian economics repeated here by Ritenour is that it is really just simplistic "intellectual ammunition" trotted out in response to the helicopter drop thought experiment. To take an even more unrealistic extreme, there is Hume's thought experiment of every one's money balance unexpectedly doubling overnight. Is the creation of money perfectly neutral? No, claim the Austrians and they are even willing to nitpick the helicopter chimera and Hume's magic.

I don't think that money creation is neutral in the real world. Exactly what it does depends on details of the monetary regime. But where some Austrians go wrong is in claiming that these nonneutralities are especially disruptive. In my view, any nonneutralities involved with money creation constrained by nominal GDP level targeting will not create any serious problems.

Ritenour continues:

Credit expansion necessarily stimulates malinvestment by encouraging production processes that are too roundabout relative to social time preferences (Strigl 1934, pp. 120–33; Mises 1949, pp. 547–62; Garrison 2001; Rothbard 2004, pp. 994–1004; Hayek 2008, pp. 189–329; Huerta de Soto 2006, pp. 347–84; Salerno 2012). Without an increase in voluntary savings, longer production processes are not all able to be completed. This is the heart of the malinvestment problem.

The first statement is false on its face. "Credit expansion?" For example, suppose people reduce spending on consumer goods and purchase bonds. This is an expansion in credit. The price of bonds rise and the yields fall. Firms respond to the lower cost of funds by selling additional bonds to fund production process that are more round about. The quantity of credit has expanded. The interest rate has fallen. But there has been a change in "social time preference" (though I find that an awkward way to characterize an increase in saving supply.) There has been an increase in voluntary saving and there is no reason to anticipate malinvestment.

Of course, Ritenour was being a bit sloppy, and by "credit expansion," he had in mind an increase in the supply of credit generated by an increase in the quantity of money. However, if the demand for money had not increased, then the resulting excess supply of money would result in greater expenditure on output, pushing nominal GDP above target. Nominal GDP level targeting is inconsistent with "out of the blue" credit expansions. As explained above, if the demand for money increased while consumption spending decreased, then the effect of the credit expansion is exactly as if the savers had purchased some other sort of financial assets directly. They are reducing current consumption and saving by accumulating money balances. By consuming less now, they free up resources to allow for more round about methods of production. The purchases of securities by banks (including central banks) or the new bank loans provide funds to entrepreneurs to undertake these more capital-intensive projects.

Of course, if the increase in the demand for money occurs through households or firms spending fewer current receipts on other sorts of financial assets, then there is just a change in the composition of financial assets being held. It is as if those accumulating the greater money balances had instead directly purchased the bonds that the banks purchased or made the loans the banks made. Finally, it is possible to accumulate money balances by selling financial assets. While this would not necessarily be "neutral," it would have no obvious impact on the degree to which production is round about. The result is the same as if those accumulating money balances had sold their assets and purchased the ones that the banks purchase.

Ritenour's problem here is that he continues to pound the same square pegs into round holes. He, like too many Austrians, remains fixated on the thought experiment where the quantity of money rises while the demand for money, the supply of saving, and the demand for investment are all held constant. While the possibility of changes the demand for money and the supply of saving is recognized (and the demand for investment is balled up in there with the supply of saving in some way,) any such changes are assumed to already shift to a new equilibrium assuming a constant quantity of money. Then the change in the quantity of money and matching credit expansion are assumed to occur from that equilibrium.

But that is an absurd approach. What happens when the supply of saving and the demand for money both change and the quantity of money changes with the demand to hold money? If it all happens at once, you can't break it down and describe a disequilibrium adjustment process for only a single part. Admittedly, Hayek tended to focus on booms that occurred due to an increase in the demand for investment, and a monetary regime that failed to raise interest rates enough to keep nominal spending stable. However, to the degree that the higher interest rates generate an increased quantity of saving supplied, a "credit expansion" is appropriate. Further, to the degree that higher interest rates on checkable deposits result in a greater demand for money, funding at least part of that added credit through additional money balances is also appropriate. Naturally, those adjustments would be consistent with keeping the level of nominal GDP on target.

Ritenour then continues:

NGDP targeting advocates end up fostering the monetary illusion that scarcity can be overcome and prosperity can be achieved via monetary inflation.

Here he goes beyond error to offense. Market Monetarists in no way propose to use monetary inflation to overcome scarcity. On the contrary, Market Monetarists aim to keep spending on output growing at a slow stable rate. We believe that this will have the consequence of reducing both the frequency and duration of periods where actual production remains below the maximum amount possible given the reality of scarcity. Further, we believe that it will reduce both the frequency and duration of periods where spending growth exceeds expansions in the amount that can be produced consistent with scarcity. I use the term "potential output" to refer to just that--the maximum that can be produced subject to the constraint of scarcity.

Why does Ritenour make what is an absurd charge? It is because over 100 years ago, Mises was very interested in refuting claims that an expansionary monetary policy can (and should) be used to permanently reduce real interest rates. Many of those making such proposals promised that this would not only mitigate the scarcity of capital, but could go so far as abolish it. And many considered its chief benefit to be to raise labor's factor share in income at least somewhat, perhaps even to 100%.

Well, Market Monetarists have not argued that expansions in the quantity of money will permanently lower interest rates or that this would be a good thing because it would result in a larger capital stock or promote social justice by impacting the factor distribution of income. Hardly anyone else makes these sorts of arguments either. (Perhaps post-Keynesians or Modern Monetary theorists go there still.)

Market Monetarists have pointed out that it is possible for an increase in the quantity of money to be associated with increased nominal and real interest rates. Admittedly, these are special scenarios associated with the introduction of a nominal GDP level targeting regime in the context of a previously existing shortage of money that has already pushed real output below the level consistent with scarcity. More generally, Market Monetarists would like to see market forces determine all interest rates, and that those interest rates should be at levels that coordinate saving and investment at levels of real output and income consistent with the constraint imposed by scarcity. We argue that slow steady growth in spending on output is the least bad macroeconomic environment to maintain this sort of coordination.

Still, it is difficult to see how anyone who knows anything about the Market Monetarist approach could make the absurd accusation that we seek to use monetary inflation to overcome scarcity. The best excuse, I guess, is again the effort to pound the square pegs into the round holes--repeating Mises' arguments against his foes from more than 100 years ago.